Tim Lee: Why bitcoin is a bubble

My friend Tim Lee says that critics of Bitcoin need to do a better job of explaining why bitcoins–the virtual currency that has been soaring to impressive heights–are in a bubble. Tim writes:

When people dismiss Bitcoins because they can’t think of how they’d use it, they’re missing the fact that Bitcoin is a platform, not a product in its own right. When ordinary users started buying computers, it wasn’t because they thought it would be cool to own a computer. They did it because they wanted to do spreadsheets or word processing or email. Similarly, ordinary users aren’t going to start using Bitcoins just because it’s a cool technology. If normal users start using Bitcoin, it will be because they’re interested in gambling, or cheap international money transfers, or some other applications that hasn’t been invented yet. And Bitcoin’s intermediary-free architecture means that many more people can try their hand at building the platform’s killer app.

I haven’t written about bitcoin before, but here’s my stab at why it’s fair to say that bitcoins are frothy: eventually, the novelty will wear off, the state will get involved, and the costs will be found to outweigh the advantages.

The problem isn’t that I can’t imagine how I’d used bitcoins. I can imagine exactly how I’d use them: to evade government surveillance of my financial transactions. This potential use seems to have tickled the imaginations of many, many bitcoin fanciers. The problem is, the government also has an imagination.

The reason I think that bitcoins will ultimately go away is that I think they will, like other virtual currencies before them, ultimately prove to be too illiquid. A dollar is one of the world’s most liquid assets: it can be turned into virtually anything I want, at least if I put enough of them together.

But bitcoins are not so liquid. Mostly, to buy things, I need to trade them for dollars or another currency. And that is the fatal weakness of bitcoins: at some point, to compete with dollars, it needs to enter the real economy. And if bitcoins become a good way to avoid government surveillance of your financial transactions, then governments will find a way to choke off those entry points so that bitcoins become very illiquid indeed. (…)

Some of those ‘technologies’ are pretty low tech. Bitcoins are essentially electronic bearer bonds. Readers of 1930s-era thrillers will remember that these often figured heavily in the plot: bonds which paid out to whoever happened to be physically holding the bond. These were very useful for refugees, tax dodgers, and criminals, and anyone else who wanted to keep the government’s eyes off their finances.

But the usefulness of bearer bonds became a problem. If your bearer bond was destroyed, you had no recourse. They also turned out to be very useful to steal, since the original owner had no way to prove their property rights. And indeed, one source alleges that about 10% of bitcoins have been stolen at some point.

Even worse, governments found a way to shut down the issuance. In fact, this proved surprisingly easy: the US government simply announced that interest payments on bearer bonds would no longer be tax deductible. And voila, no one wanted to issue bearer bonds any more.

(…) In other words, I think that governments can make it so difficult to translate your bitcoins into the real economy that most people simply won’t bother. And the more successful that bitcoins are–the better they become established as an alternate currency–the more likely it is that rich-world governments will swoop in and make it prohibitively difficult to use bitcoins to procure real-world goods in developed countries. At that point you’ve essentially got a novelty currency like greenstamps, which can be exchanged for only a limited supply of goods, and maybe some developing-world travel.

Given that, bitcoins seem overvalued to me. People are betting on bitcoins as an actual substitute for money, not a novelty currency. And while I wish the bettors luck, I think they’re facing some pretty long odds.

On the bitcoin-as-platform concept, my friend Charles writes “Bitcoin is really a template for a whole family of shared distributed ledger systems that can potentially solve all kinds of problems without any central authority being involved.” Personally I think Charles has the best perspective on the future utility of this machinery. The “Killer App” of bitcoin may not involve bitcoin as medium of exchange.